Public Bill Committee

[Mr. Jim Hood in the Chair]

(Except clauses 3, 5, 6, 15, 21, 49, 90 and 117 and new clauses amending section 74 of the Finance Act 2003)

Amendment proposed [this day]: No. 132, in clause 55, page 27, line 31, leave out subsection (4).—[Mr. Breed.]

Question again proposed, That the amendment be made.

Jimmy Hood: I remind the Committee that with this we are discussing the following amendments: No. 134, in clause 55, page 27, line 31, leave out ‘are treated as always having had effect’ and insert
‘shall have effect from 6th April 2008’.
No. 135, in clause 55, page 27, line 33, leave out subsections (5) and (6).

Jane Kennedy: Before our break, I was explaining the impact of the court’s decision in December 1986 and how that decision came as a surprise, not to say a shock, to the Inland Revenue, to other tax authorities around the world and to most tax advisers. The problem was not confined to the UK-Jersey tax treaty. Parliament acted at the next available opportunity—in the 1987 Finance Bill—to make it clear that the UK’s treaties did not give, and never had given, tax exemption to a UK member’s share of a foreign partnership’s income. During the debate on the 1987 Bill, there was an exchange between the then Financial Secretary to the Treasury, now Lord Lamont of Lerwick, and my party’s spokesman, Tony Blair. If I may quote more widely from the Committee’s debate than did the hon. Member for South-West Hertfordshire (Mr. Gauke)—it is always good to make what was said clearer and not to draw on too narrow a quotation—the then Financial Secretary said:
“The hon. Member for Sedgefield has made some good and telling points—he always does in Committee.”
Tony Blair then said:
“I believe that the right hon. Gentleman has put as good a case as possible in defence of the retrospection within this clause”,
although he doubted whether the same argument would stand in other examples. The then Financial Secretary observed that although the provisions had caused him “considerable concern”, he had concluded that the clause should apply with retrospective effect. He noted that that did not involve the
“type of retrospection on which the House has normally looked with disfavour”
as all that it did was to
“restore the general understanding of the law to what it was before a decision of the High Court.” —[Official Report, 15 July 1987; Vol. 119, c. 1180-87.]

Colin Breed: Will the Minister tell the Committee how many years back that retrospection went?

Jane Kennedy: I will seek to answer that later, but the retrospection was extensive.
UK individuals and companies have been artificially routeing their income through offshore trusts and partnerships and claiming that one of the UK’s many double taxation treaties exempts them from tax. That is in wilful contravention of the purpose of the treaty and the 1987 legislation. A fundamental purpose of the clause is to put it beyond doubt that a wholly artificial avoidance scheme designed to frustrate legislation passed by Parliament in 1987 to prevent such avoidance does not work, and never has. Some taxpayers were awaiting the outcome of litigation in the expectation that it would clarify their affairs. The legislative change in the clause will result in the necessary certainty, not litigation, thus enabling tax returns to be finalised.
Many descriptive terms have flowed in the discussions that I have had about this avoidance scheme, one of which is “an egregious case”. In such a case, the Government consider that the law already defeats the scheme and that it is clear to all concerned that the scheme is in defiance of Parliament’s intent. Used in such a context, retrospection preserves the expectation that tax will be applied fairly and consistently. That will build confidence and trust in the law. Nobody could seriously think that the clause is unfair to the people who will be affected by it. Users of the scheme have deliberately tried to frustrate the will of Parliament, and they will have been aware that Parliament had closed down similar schemes 20 years ago with retrospective effect. My understanding is that that retrospectivity was unlimited, in effect, until the end of the second world war.
The Committee might not be aware of the scale of the risk to the Exchequer as a result of this avoidance scheme. HMRC is aware of more than 2,000 scheme users, and it involves tax of £50 million a year—a not insubstantial sum. Given the increasing numbers using the scheme, the rapidly growing amount of tax at risk and the wilful attempt to circumvent the clear purpose of the legislation and of the UK’s tax treaties, we consider it appropriate to legislate to provide retrospective clarification and to put the matter beyond doubt. HMRC has learned that the large number of taxpayers who have been using the scheme has suddenly started to grow; I shall explain why in a moment.

David Gauke: I acknowledge that the number seems suddenly to have increased, but will the Financial Secretary clarify when HMRC first became aware that such schemes were being created?

Jane Kennedy: I will do that in a moment, if the hon. Gentleman will allow me.
The scheme is similar to the Padmore scheme except that UK taxpayers set up offshore trusts as well as partnerships. The trusts are for their own benefit, and the trustees become members of the partnership. UK taxpayers agree to work for the partnership, so that once a scheme is set up, their UK income thereafter becomes payable to the partnership and, through the trust, it is paid straight back to them in the UK. They assert that such an arrangement circumvents the 1987 legislation so that the income is tax-free. HMRC does not believe that the scheme works, but we have taken into account its scale and the wilful attempt to flout the law that retrospectively clarified how tax treaties work. The Government have developed our approach on the detail of the legislation on anti-avoidance rules generally to ensure that they are effective and properly targeted. Business welcomes that approach, and it has led to better legislation.
Let me respond to the point raised by the hon. Member for South-East Cornwall. In 2004, the then Paymaster General gave a warning in relation to a particular abuse. Her statement gave no reassurance about use of retrospection on other matters, and certainly did nothing to suggest that the Government would act differently in relation to treaty abuse than they did in 1987.
The Government do not accept that the clause changes the meaning of the law. The law already applies to partnership profits, and we interpret that as including profits enjoyed through a trust. The measure clarifies rather than amplifies the scope of the 1987 legislation and puts beyond doubt what most people understand it to mean. We recognise and acknowledge the difficulties inherent in such legislation. Although the clause is strictly retrospective, as was the case in 1987, it does not change what is generally understood to be the meaning of the law but merely clarifies it.
The hon. Member for Gosport is not in his seat at the moment, but I should put it on record that HMRC guidance merely noted that some tax planners suggested that circumventions were possible. HMRC did not accept that view of the law, and it does not accept it now. It did not see evidence that such schemes were being used until 2001. However, their use has increased sharply in the past year, which is why we are acting now. The discourager regime provides HMRC with early information on tax avoidance. In many cases, it will respond to the information by challenging the avoidance in the courts. In some cases, it will be appropriate for the Government to legislate to prevent future use of a scheme or new variants on it. In rare cases, such as those we see today, it will be appropriate for us to act retrospectively to ensure that abusive schemes are closed down by legislation rather than litigation. There are no cases of litigation at the moment.

Mark Field: We all accept that Parliament’s desire should hold sway, but the issue is surely one of clarification. The correct place to clarify the law is in the courts—it should not be done merely by ministerial assertion or Treasury diktat. That is the Conservative objection to the measure. Clarification must come through the proper legal process.

Jane Kennedy: The hon. Gentleman and I will clearly have a disagreement on that.
Subject to an exception relating to judicial decisions made before 17 March 1987, the legislation applied retrospectively. Therefore, the provision did not apply to Mr. Padmore or to a few other taxpayers. In relation to the scheme, some taxpayers were awaiting the outcome of litigation in the expectation that it would clarify their own tax affairs, but no litigation has ever commenced. The change in legislation provided by the clause will provide the necessary certainty instead of litigation and enable tax returns to be finalised.

David Gauke: The Minister says that in the opinion of HMRC, the clause merely clarifies the existing law, and that there has been no litigation. That is presumably because HMRC has not pursued litigation. If HMRC is so confident that the measure merely clarifies the law—I am not making a case one way or the other—why is it not bringing litigation against the users of the scheme?

Jane Kennedy: Because the opportunity arises to deal with the matter through legislation and to make it clear that, as HMRC already believes, the scheme does not work. The change that we are making has already had an impact on the number of notifications of the scheme. As I said, there is a risk to the Exchequer on the scale of millions of pounds.

Peter Bone: I have been listening to the debate and I am not quite sure why the measure must be retrospective to save money for the Exchequer. If the Bill is enacted and taken forward, will that not save money? I must have missed something.

Jane Kennedy: As I understand it, a number of people are proposing to use the scheme and some tax advisers will recommend the use of it unless we act to make it clear that the scheme does not work. The legislation will end the doubt about that.

Peter Bone: I think the Minister is making my point: if we enact the measure now, there is not a problem going forward—I agree with her entirely. However, I do not understand why we have to throw back the measure.

Jane Kennedy: I hope I get this right. It is because HMRC has not consistently made the case throughout the time period that the scheme does not work, that it is a deliberate and wilful avoidance scheme that flouts the 1987 legislation, and that it would be challenged.

Philip Hammond: The Minister has said that HMRC regards the scheme as a wilful flouting of the law, but apparently it has never brought a case. When she answers the question of my hon. Friend the Member for Wellingborough about why it cannot simply be a prospective proposal, can she say how much back tax—disputed tax—rides on the retrospectivity aspect of the measure?

Jane Kennedy: That is a fair question, to which I have not immediately got an answer. I hope to have the answer, but if I do not, I will certainly write to the Committee.
It is not right to say that HMRC turned a blind eye to the scheme, did nothing and waited until legislation became necessary. HMRC’s early challenges around the scheme—although not litigation—did meet with some success. It strongly believes that this is an exceptional circumstance and that none of the scheme users could have been in any doubt that they were deliberately flouting the clear intention of the 1987 legislation.

Mark Todd: My understanding is that if one did not make the measure retrospective, one would implicitly be saying that there was some validity in the evasion technique, and that that is the answer to the point made by the hon. Member for Wellingborough.

Jane Kennedy: My hon. Friend is right. Looking back, the sum is around £200 million. As I have said repeatedly, in HMRC’s view, someone not would have used the scheme without knowing exactly what they were doing. Early scheme users did concede to HMRC arguments and the usual preliminary steps were taken towards litigation. However, the growing use of the scheme had begun seriously to threaten revenues, which led to unacceptable uncertainty. This was thought to be by far the most appropriate way of dealing with it. It was signalled well in advance that such a step would be taken.
I have received one or two representations on the matter, but I understood that there was broad acceptance that the Government were expected to take this step. The hon. Member for South-East Cornwall says that that is not the case, but I have seen only one or two representations, and I was not aware of that concern being widespread. I was about to speak about the Rees rules, but I happily give way.

David Gauke: I shall read again what some public bodies have said. The Chartered Institute of Taxation says, “extreme and unjustified”. The Law Society says, “wrong in principle”. The Institute of Chartered Accountants in England and Wales says,
“it sends out a very damaging signal about the stability of the UK tax system”.
At the HMRC and Treasury open day for the Finance Bill, a long list of representations were made by those bodies and others, including KPMG and the Institute of Chartered Accountants of Scotland. All were expressing great concern, not about closing the loophole but about the retrospective element.

Jane Kennedy: I will reassure myself that my understanding is accurate. I shall consider the point made by the hon. Gentleman, because I want to be absolutely sure. However, given what I understand of the scheme, such representations are surprising to me. When we change the law to combat clearly abusive avoidance arrangements, we may exceptionally—very exceptionally—do so with retrospective effect.

Philip Hammond: I have not studied the subject like my hon. Friend the Member for South-West Hertfordshire, but does the Minister accept that there is a difference between a court making it clear that the HMRC interpretation is correct and that the taxpayer interpretation is incorrect and the Government then moving to legislate retrospectively, effectively in order to implement the court’s decision and what she is doing now? The Minister is merely asserting that the taxpayer is wrong and that HMRC is right without being prepared to let the courts test that view.

Jane Kennedy: We regularly legislate in Parliament, and the legislation is often tested in court. If Parliament’s view of the law is found to be unjustified by a court and if Parliament believes that its view should carry, it is perfectly proper for the Government to revisit the matter—

Philip Hammond: That is what we are saying, but after the court hearing.

Jane Kennedy: In 1987, a court judged the law to be deficient. As I said, the judgment was a complete surprise to everyone in the field; there was thought to be universal acceptance that the legislation was right. It was based on long-used double taxation treaty legislation. As one would expect, the court’s decision required a study of what had gone wrong and of where the law was deficient. I am happy and content, given the advice that I have received, that the decision I am asking the Committee to make today is right.
I am not going to dwell on the point, but it is a point worth making. We are engaged in discussions about a taxpayers charter, and have invited representations. The Chartered Institute of Taxation submitted suggestions of what such a charter might do. Section 13 includes this statement:
“Where we change tax law to combat clearly abusive avoidance arrangements, we may exceptionally do so with retrospective effect.”
I am not asking the Committee to do something absolutely outlandish and outwith the expectation of the industry, although I accept the point made by the hon. Member for South-West Hertfordshire about the number of representations that he has seen and will seek to reassure myself about the advice that I have had.

Mark Field: I confess that I was unimpressed by the Minister’s answer to the earlier intervention by my hon. Friend the Member for Runnymede and Weybridge. A set mechanism is in place. In so far as the scheme can be challenged in the courts, she is absolutely right to say that the Government have an opportunity to come back and make new law to close any loopholes, but she is arguing that there is no loophole that the Government recognise. Does she not see our perspective? We fear that down that road—although, admittedly, a fair way down it—lies tyranny.

Jane Kennedy: No. The hon. Gentleman will remember that the court decision led to the legislative decision in 1987, which related to the abuse of partnerships and the arrangements concerning them. We now see the scheme developing in a way that HMRC believes strongly will not work. I ask the Committee to agree to clause 55 because the Government are absolutely clear that the view taken by Parliament in 1987 was the right view. Even though it was taken by a different party, we stand by that decision. I believe that we can pass the clause with a clear conscience.
The Rees rules do not govern all possible situations in which the Government might introduce retrospective legislation; they apply where the Government seek to close down a scheme with immediate effect. There are a few exceptional cases, such as this one, where closure with immediate effect would not be adequate to counteract the avoidance in question.
Tax avoidance is unfair to the great majority of taxpayers who pay their fair share. We discussed the nature of avoidance earlier. I can understand that people want to reduce their liability, but where a scheme is in clear and deliberate breach of the law, Parliament has a duty to act to protect the Exchequer. None of the scheme’s users was entitled to artificially avoid paying their fair share of tax at the expense of others. They ought to have been aware of the likely consequences of their wilful attempt to flout the law. The 1987 decision to tackle treaty abuse with retrospective effect was a clear signal. I hope that the amendments will not be pressed to a vote. If they are, I hope that my hon. Friends will resist them and that clause 55 will join the rest of the Bill.

David Gauke: I do not think that the Minister has reassured Conservative Members at all. There is an essential contradiction in what she said. She said that HMRC is confident that the clause merely reasserts existing law, that it is not a change in law and that the schemes are in clear breach of the law, yet she suggests that some £200 million in back tax is at risk. If the law is as she says—I have no reason to doubt it—that sum is not at risk, because all that is required is for HMRC to litigate. It prompts the question why HMRC will not litigate. Why is it not prepared to take the matter to court?
It relates to the point made by my hon. Friend the Member for Cities of London and Westminster. The Government are saying, essentially, that they will pass new law if they think that the law is in some way flawed or there is an alternative interpretation of it that they do not like. Rather than allowing the courts to interpret that law, they will rewrite it retrospectively so that it says what they wanted it to say in the first place. Such an approach gives individuals and businesses no reassurance that the law is what they think it is, as it is written down and what has been passed by Parliament. The impression is that it is something that can be changed if not at a whim, at the discretion of the Government retrospectively.

Philip Hammond: Does my hon. Friend agree, that for the purpose of clarifying the law and sending out signals about it to the business community, the Government should have legislated to correct any confusion or doubt in the law as soon as they became aware of it? The Minister implied that the reason behind the need to move now is that the use of the avoidance technique has suddenly increased significantly. She should take on board the lesson that the way to avoid being in such an embarrassing situation is to legislate as soon as a defect is spotted. Everyone will then have a clear picture of what is going on.

David Gauke: My hon. Friend takes me to my second point. However, I must say first that certainty in the taxation system is important. We have a well-developed legal system that should work on the basis of laws being interpreted on the grounds of what they say, not what the Government want them to say—even if that is not what they said at the time.

Jane Kennedy: Is the hon. Gentleman asking us to believe that his party, and to some degree the party of the hon. Member for South-East Cornwall, believe that aggressive tax-avoidance schemes such as that under discussion, which are widely seen as abusive, should be allowed to continue during litigation at risk to the Exchequer, and that there should be no circumstances in which he would do what his party did in government, which was to legislate and to apply it retrospectively?

David Gauke: A Government should pursue and litigate on the basis of the existing law. When they identify an abuse, they should issue a warning and announce that they will change the law at the first opportunity, and then do so. That takes me to the point made by my hon. Friend the Member for Runnymede and Weybridge. The Minister said that HMRC was first aware of the schemes in 2001, but they were not pursued widely because the warnings given by HMRC proved to be sufficient. None the less, there was an awareness at that time by HMRC of some ambiguity in the wording of the 1987 legislation.
Notwithstanding the fact that the schemes were not being pursued, why were such measures not introduced under the Finance Act 2001 or subsequent Acts? There has been plenty of them. Given that there were two Finance Acts in 2005, there have probably been about eight. The matter causes great concern, and the Government’s approach should be to pursue it rigorously and to litigate if there is some doubt about the law. In the meantime, warnings should be given and legislation should be made. The Government have not done that. They have sat on the matter, have come back subsequently some years later and taken action when the scheme started to develop, having been aware of the ambiguity under the 1987 legislation.
In response to the hon. Member for South Derbyshire, I must say that, if the Government fail to make the measure retrospective, it is an admission that the previous legislation was defective. Indeed, I am more inclined to interpret the proposal to make it retrospective as an admission that the 1987 Act does not do what the Government said it does. That is not based on a legal analysis but, if they were so confident that the 1987 legislation prohibits the behaviour that we are talking about, why on earth have they not litigated on the matter?
For those reasons I am more convinced than ever that the retrospective nature of the clause is unacceptable. Should the hon. Member for South-East Cornwall wish to press his amendment to a vote, we will support him.

Colin Breed: We are somewhat in danger of this aspect moving from retrospection to repetition. At the end of the day, I am not certain, although there has been much repetition, whether it has made any great difference. To begin with, we talked about reasonable expectation. I am a fairly reasonable chap, and I know that the Minister is a reasonable Minister. I thought that there was a reasonable expectation that the Government might accept the powerful arguments—made not only by Opposition Members, but by a huge number of interested bodies—about the central concern.
We all agree that we want to stop the tax avoidance. There is not much disagreement on that at all. The central concern is how the Government have decided to achieve that—first, not to go through the court situation, to clarify and confirm their thinking anyway, but then the wide nature of the wording in subsection (4). It cannot be beyond the experience, knowledge, skill and such of those who draft legislation to draft a subsection to bring about a tighter situation, clearly concerned with the tax avoidance that the Government wish to close down and clarify straightaway. The current wording is so wide—that is our concern and that of many others.
Some time ago now, we talked about whether the measure would be subject to human rights legislation. The Minister said that it would be fair, proportionate and in the public interest. It is difficult to think that undertaking such wide application of the subsection is fair or proportionate—it might well be in the public interest, in terms of the money derived for the Revenue, but one out of three is probably not good enough. No reference has been made to the whole principle of the method, although I understand that the taxpayers charter will refer to retrospection. As the Treasury Committee pointed out some time ago, it would be extremely helpful to have a real paper, so that we understand the principles of any potential future retrospection in any such legislation, so that we can see clearly how such retrospection might be applied and so that we do not have such wide drafting as we have in the subsection.
I am happy to indicate that we would support a clause, subsection or some other drafting that narrowly defined the retrospection to this particular tax avoidance scheme, so that there can be no doubt whatsoever that it applies only to that, which is what the Minister has said on a number of occasions. That is what we would be happy to support. I hoped that, even at this late stage, that might be the sort of thing that would be forthcoming, together perhaps with a draft paper on the principles of retrospection. In the absence of that, I feel that we have no option but to press the amendment to a vote.

Question put, That the amendment be made:—

The Committee divided: Ayes 7, Noes 13.

Question accordingly negatived.

Clause 55 ordered to stand part of the Bill.

Clauses 56 and 57 ordered to stand part of the Bill.

Nick Palmer: On a point of order, Mr. Hood. Could we be updated on the health of the gentleman who had a problem on Tuesday? Will you consider sending him a card on behalf of the Committee saying that we look forward to seeing him again soon?

Jimmy Hood: I appreciate the hon. Gentleman’s concern. I expressed my concern and that of the Committee this morning. I am assured that the gentleman is recovering and resting, and that it will not be long before he is back at work.

Schedule 21

Restriction on loss relief for non-active traders

Philip Hammond: I beg to move amendment No. 136, in page 274, line 22, at end insert ‘, and
(c) the trade is carried on with the intention of generating a loss for tax avoidance purposes.’.
I am sure that all hon. Members are delighted at the spurt of progress that we have just enjoyed and which I now intend to stop dead in its tracks. The schedule deals with restrictions on trade loss relief for individuals. That was not mentioned in the Budget speech, but was buried away in Budget note 63. It is effectively retrospective, not in quite the way that we have discussed in relation to previous clauses, but in the sense that it will impact on the treatment of decisions made before the measure was known about.
A significant step is being taken. The provision is being introduced under the guise of an anti-avoidance measure, so the Government, using their own principles, avoided extensive consultation on it. It removes what is in effect the oldest form of encouragement for enterprise in the tax code. I should be grateful if the Minister would tell us the scale of the mischief—I use the word again—that we are addressing. I understand that in conversation senior officials at HMRC indicated that HMRC has no idea of the extent of any “avoidance” through the use of sideways loss relief by individuals, no idea whether it is costing the Exchequer money, and thus no idea of what the relief is worth. That makes this look like a fishing expedition. We on these Benches are concerned that the Government are proposing legislation that will impact on not just the incentive to take business risks, but on individuals’ ability to take on risk, and that they are doing so without any clear idea of the loss to the Exchequer—if they believe that there will be a loss—or of how much they will gain from the measures.
Under current legislation, an individual who carries on a trade can offset losses arising in that trade against other income and gains. That is known as sideways loss relief. There is a provision, in section 66 of the Income Taxes Act 2007 in its most recent incarnation, which denies any such relief if the trade is not operated on a commercial basis. That is a perfectly reasonable restriction to impose and it ought to be sufficient to ensure that the measure cannot be used for the purposes of artificial avoidance.
A fundamental issue is at stake here; individuals are taxed overall on their total income—certainly within any of the particular silos by which income is taxed. The Government are effectively seeking to introduce a sort of mini-scheduler approach within trading income, so that an individual is taxed separately on their income from different trades. That would have a significant effect. We are all aware that the Finance Act 2007 introduced provisions restricting the ability of partners in a partnership who were not actively engaged in the business of that partnership to obtain sideways loss relief. That was introduced to prevent artificial constructions that allowed individuals to take advantage of the losses generated in partnerships.
Schedule 21 provides for similar restrictions to be applied where an individual carries on a sole trade in a so-called “non-active capacity”. That raises different issues. Under the measure, where the trader is defined as a “non-active trader”, the amount of sideways loss relief is limited to £25,000 annually, unless the trade relates to film expenditure, in which case there will be no such restriction. Amendment No. 136 inserts a motive test into that through a provision that means section 74A will apply only if the trade has been carried on with the intention of generating a loss for tax avoidance purposes.
In my humble opinion, my amendment is redundant—that may sound like a slightly strange thing to say—because section 66 of the Income Taxes Act 2007 already requires business be carried on for a commercial purpose, that is, for the purpose of making a profit. The amendment has been tabled to draw attention to that problem and to probe the Minister on the extent of the catchment of the clause by highlighting how a motive test would narrow it down.
What problems do we see in relation to the provision? According to schedule 21, an individual is thought to devote sufficient time to a trade for him to be considered an active participant, if he
“spends an average of at least 10 hours a week personally engaged in activities of the trade and those activities are carried on...on a commercial basis, and...with a view to the realisation of profits”.
The 10-hour rule is an arbitrary and unsatisfactory way of defining an individual’s contribution to a business. It does not begin to address many of the real world situations in which people find themselves. It will also create a bureaucratic nightmare, which is the antithesis of the entrepreneurial spirit that the Government say they want to foster. Imagine an enthusiastic entrepreneur engaged in starting up a part-time business. When he gets home from his hard day’s work in employment and goes out to his garage, where he is in the process of creating the next Hewlett Packard, he will presumably need to clock on and record on his time sheet the hours he is committing to that new venture in order to produce records to satisfy HMRC that he is committed to that enterprise for more than the requisite 10 hours a week averaged over the tax year.
If we really want to foster a culture of entrepreneurship in this country, not only is that requirement patently absurd and unenforceable, but even the thought that entrepreneurs should be encouraged to think in that way about the hours that they put in to developing start-up businesses is depressing. There are many wholly commercial reasons why an individual might not spend 10 hours a week personally engaged in a trade. Having taken the risk of establishing a business and built it up by the sweat of his own labour, an individual might be in a position to employ others to run it while he is engaged on the next venture, and I would have thought that the Government would want to encourage such serial entrepreneurship. The hard-working entrepreneur who, having built up a restaurant, small guest house, pub or hotel business, wants to move on and devote his time and energy to building up another venture will fall foul of these rules unless he goes back and spends 10 hours a week pulling pints at the bar in order to qualify under the tests that the Government are imposing.
Many individuals start up businesses while still in employment—a point to which I have already alluded. That is a sensible way of probing the viability of a new business venture without sacrificing the security of a regular income. Many people work full time or part time for an employer while conducting a part-time business, and sometimes more than one. Indeed, I remember meeting a constituent of mine shortly after I was elected who was employed in the catering department in the House of Commons—I can tell this story because he no longer works here—and who very enterprisingly was conducting a business as well, manufacturing and distributing hand-cooked vegetable chips, and very delicious they were too. He eventually left the employment of the House of Commons and has, I am sure, prospered elsewhere. That is not an unusual case. Hon. Members will know of many people who have tested the water with a new business project while retaining the security of their existing employment.
Some businesses are seasonal, such as furnished lettings, and there are also smallholding agricultural businesses, which people might not be able to turn into a viable full-time occupation. That is less part of the culture of this country than it is of some of our European neighbours, where part-time agriculture is a common business occupation. We believe that there could be a serious impact on start-ups and on the fostering of entrepreneurship, especially in the wake of the Government’s decision to abolish taper relief and the negative signals that that sent to those engaged in establishing new business enterprises.
I am afraid that it gets worse because new section 74A(6) provides that if an individual has received sideways loss relief in his capacity as a partner in a partnership, that amount has to be deducted from the cap that this measure proposes. That would be a further reduction in the capacity to absorb losses across the boundaries of different trades.
I have a number of other points to make on schedule 21. As I have gone this far, it might be better for me to complete my remarks, unless you indicate otherwise Mr. Hood. The Minister could then respond to the amendment and to the more general remarks, rather than have a separate debate on the schedule.

Jimmy Hood: Order. I have no objection to the hon. Gentleman discussing other parts of the schedule, but we will not then have a separate debate on the schedule.

Philip Hammond: That was exactly my thinking, Mr. Hood. It is precisely because I fear that I may already have strayed into some of the more general points that I suggested that I carry on.
The Government say that these measures are aimed at tackling contrived arrangements. We have no problem with that, but the legislation is very widely drafted. It is our contention that it will also catch some wholly commercial arrangements. A normal, industrious trader who seeks to establish a new business, or businesses, could be inadvertently caught in this trap. New section 74B(3) and (4) provides that no relief will be available where loss arises as a result of relevant tax avoidance arrangements. That is fine, but the relevant tax avoidance arrangements are widely defined. When claiming sideways loss relief, will an individual have to prove that he had no expectation at the outset that such a loss could be relieved? In other words, it appears that one can benefit from sideways loss relief only if one is not aware that one could benefit from it. Perhaps the Minister would clarify that point.
Could somebody be caught by these provisions as the result of a negative decision? I return to my earlier example of somebody who has established a business that is running quite successfully. He has employees who are running it for him and he wishes to devote his attention to his next business venture. He is a classic serial entrepreneur. Could HMRC treat his failure to incorporate that first business as an act that was seeking to exploit the possibility of the use of sideways loss relief?
We are in uncharted territory. It has always been understood that people with an established line of business that is generating profits can, with the security of that profit income, invest in a new business activity or trade, and that any losses in that new trade can be offset against their income from the existing trade. By definition, one might think that asking them not to devote their full energy to the new trade, and to take a chunk of their working time and attention and continue to focus it on existing trade, to satisfy HMRC’s requirements in the test that is introduced by the legislation, would make the chance of incurring a loss in the early years of the new trade rather greater, because of the reduced attention and focus given to it.
The Budget day news release dealt with the purpose of the provisions, and said that the
“Government made clear that avoiding tax through the use of sideways loss relief is unacceptable.”
However, the provisions mean that genuine traders may not be able to claim statutory relief, which could lead to individuals being taxed on more than 100 per cent. of the net result of the profits and losses on all their business activities, where losses and profits cannot be offset.
A particular case that could arise is one in which someone who was setting up a new business was taking advantage of the annual capital allowance to invest in it but, because that new business had no profits, they would seek to offset the value of the capital allowance against the existing profit stream from their established business or businesses. That will now no longer be allowed beyond the £25,000 limit. In discussions on the matter, it has been suggested that investment in plant and equipment up to the annual investment allowance could be exempt when calculating the loss for the purposes of applying the cap. Otherwise there is a danger of hindering investment in plant and equipment in the new business.
Perhaps the Minister could give the Committee some examples of the contrived arrangements that, presumably, she fears, so that we can distinguish them from the normal trading arrangements that we fear will be caught by the wide scope of the legislation, with all the damage that that will do. The effect of paragraph 6 of schedule 21 is to make the provisions retrospective. If a loss arises in a basis period ending after 12 March 2008, that loss will be time-apportioned between the periods before and after that date, and the proportion deemed to arise after 12 March will be subject to the loss restriction, even though the loss may have arisen before 12 March.
I should like to return to the definition of a non-active capacity. In the modern world, where many businesses of all descriptions are pushing the boundaries and frontiers in technology and the way in which business is done, simply to use a test of the number of hours of direct personal involvement is simplistic. An individual might have specialist knowledge, for example, or some unique reputational value to the business that would mean that his presence—even his name on its letterhead—had a significant impact on its prospects. Someone might be absolutely essential to the functioning of the business, yet might not spend, or need to spend, 10 hours a week conducting that business. He might be the proprietor of the formula that the business is allowed to use without charge, for example. I urge the Minister to consider again whether the simple 10-hour test is really the message that the Government want to send about how they value individuals’ input into a business. We can anticipate, I think, the fact that the same argument will arise in relation to income shifting. Is it simply about how much time somebody commits to the business, or about the unique qualities and characteristics that they bring to it?
In conclusion, if there is abuse through artificial arrangements, we would support a targeted attack on that abuse, but that must not become an attack on risk taking, entrepreneurship, or start-up or spare-time businesses. The Opposition are deeply concerned that the Government are removing a fundamental part of the support system, particularly for new businesses, but also for serial entrepreneurs, which is absolutely not the direction in which the UK tax system should move, nor—this is perhaps more significant—the direction signalled in Government rhetoric.
HMRC appears to be saying in the proposals that individuals should not take risks; that, if they have an income from an established business or employment, they should not risk any of it. If they do take risks, that will be entirely at their own risk, and they will be taxed on the gross income from those other sources, rather than on the net income at the end of the process after taking into account losses incurred through investments made in genuine commercial ventures. I would differentiate between genuine commercial ventures and contrived arrangements. The Opposition believe that section 66 of the Income Tax Act 2007 already provides sufficient protection against contrived arrangements where HMRC can show that a business has been established for reasons other than generating a profit and running a commercial enterprise.

Mark Field: Regrettably, the presumption behind the sideways loss-relief provisions proposed in schedule 21 seems to be that individuals are trying to take HMRC for a ride. As my hon. Friend the Member for Runnymede and Weybridge rightly pointed out in his extensive contribution, the Opposition do not wish to allow contrived schemes to go through, and it is quite right that they be stopped. However, the Government perhaps fail to understand simply how haphazard and lacking in calculation many new business ventures are. As he pointed out, in a world in which more and more people are entering consultancy work, running their own, and expanding, businesses, forming different partnerships and, therefore, receiving different income streams to help kick off those businesses, there is a real worry that a particularly eagle-eyed HMRC inspector could make such business expansion, which we all recognise to be in the interest of UK plc, ever more difficult.
Clearly, many such businesses are not contrived, but some individuals develop their businesses haphazardly. As my hon. Friend said, a business might start in someone’s garage and take up just a couple of hours at the weekend but, as the excitement and buzz of the new idea grow, so the business might take up ever more time and costs—both absolute and opportunity costs. It would be wrong if people setting up such businesses, many of which are in the service sector, are unable to utilise some of the sideways loss-relief provisions for business ventures that are already up and running. It is feared that the Government do not recognise how much change there is in the world of work. Individuals are no longer simply employees or self-employed. There is now much more of a mix, and people are willing to develop new ideas. Just as it would be wrong to encourage contrived schemes to avoid paying tax, we should, as far as we can, encourage provision for those individuals who are willing to take risks to be properly rewarded within the context of the tax scheme.
Amendment No. 136 makes it clear that out-and-out contrivances are not right. Neither the Treasury nor the Opposition would support them. The amendment states that the trade should not be carried on
“with the intention of generating a loss for tax avoidance purposes.”
However, I fear that the authorities believe that everything involved in setting up new businesses is far more regimented and organised than it probably is. We should do nothing to discourage that entrepreneurial spirit.

Jane Kennedy: HMRC has received evidence through the disclosure regime and other means that there is up to £1 billion of avoidance activity through this scheme. The measure follows action taken against partnership avoidance last year, and the scored yield reflects this: the projected revenue that we are protecting is £245 million, £80 million and £50 million in the next three successive years.

Mark Hoban: The Minister said that there was £1 billion-worth of avoidance activity in this area, yet the figures for the next three years come to less than half of that sum. Can she reconcile the two statements?

Jane Kennedy: My advice is that that is the clear activity in this scheme, which is why the UK Film Council was very concerned to make sure that robust action was taken. I will provide a specific answer to the point made by the hon. Gentleman in a moment. It is important for the Committee to understand that this is not an unexpected response from the Government. Deloitte, in its full Budget commentary, said:
“This change was expected and shows how HMRC has benefited from the information received under the disclosure regime.”
The provision is working, and the UK Film Council states:
“We have made clear over and over again that the Government will take action against tax avoidance schemes and that’s what they’ve done today.”

Philip Hammond: I am not quite sure why the Minister is quoting the UK Film Council, as they are the only people who are exempt from the impact of the Bill. I made it clear that we would support measures to deal with contrived avoidance arrangements. I asked her to give examples of this scheme that allow a contrived arrangement that can be distinguished from the ordinary, commercial activity to which my hon. Friend the Member for Cities of London and Westminster and I referred. She talked about £1 billion, so there must be quite a lot of it. I should be grateful if she could explain how it works.

Jane Kennedy: If the hon. Gentleman allows me to develop my argument, I will explain exactly how I arrived at my view that this is the right action to take. The hon. Gentlemen has made a reasonable argument and asked a reasonable series of questions—questions which I, too, ask when I decide whether an avoidance scheme of this nature should be tackled in this way.
I was quoting the UK Film Council, and I will address directly the point that the hon. Gentleman made about it in a moment. The council said that it had made it clear that action would be taken. It went on to say:
“The only specific tax relief for the production of films is the film tax relief, which has been structured to help filmmakers. Everything else has a large health warning attached to it.”
That was its quote on the day. The provision concerns only losses that arise from the old film tax reliefs for films completed before 31 December 2006, or for films in production on 1 January 2007, which are subject to the transitional rules. We had a pre-existing commitment to those films. The restrictions will apply to film losses generally, except those covered by the transitional arrangements.
The hon. Gentleman seems to think that the measure is retrospective. Neither the operation of the purpose test nor the annual limit is retrospective. The purpose test applies to arrangements made on or after Budget day—12 March 2008. The annual limit applies to a loss with a basis period ending on or after 12 March. This targeted and proportionate anti-avoidance measure is designed to prevent aggressive avoidance. However, I have acknowledged that there is some justice in the hon. Gentleman’s argument that it is possible—I have been concerned about this—that the measure will have an impact on a small number of non-avoiding, sole-trader businesses. I shall say more about that in a minute.

Mark Field: I am interested to hear more. Given that there is allegedly a £1 billion problem, will the Financial Secretary give specific examples of the contrived schemes that are getting away with it, but which will be caught under schedule 21? I would like an idea of the type of contrivances that she has in mind.

Jane Kennedy: I am advised that we do not identify individual schemes. The schemes that we are discussing are used by wealthy individuals to access large losses that they set against other income or gains. Large up-front losses are generated by exploiting the capital allowances rules and special tax reliefs and generally accepted accounting practices that provide accelerated deductions for expenditure. The individuals concerned use the losses to reduce their tax liability. I can give the hon. Member for Cities of London and Westminster examples of the features that are regarded as completely unacceptable.

Mark Field: The Financial Secretary mentioned “wealthy individuals” who are creating very large losses for the purposes of offsetting in the way that she described. Can we take that as an assurance from her that people such as small entrepreneurs setting up their own consultancy business while in full-time employment to see whether an idea will run will not be caught under schedule 21? That is the reassurance that my hon. Friend the Member for Runnymede and Weybridge and I seek.

Jane Kennedy: I will come to that in a moment, but first I would like to deal with one or two other points. However, I hope that I will be able to give the hon. Gentlemen that assurance.
Examples of other unacceptable features include: inflating the loss relief by the use of loans so that the relief exceeds the money contributed by the individual; and the buying of an asset by an overseas intermediary in a tax haven at a price far in excess of historical costs. There are other examples. On this issue, there is probably no difference between us. The debate relates to the proper concern about whether innocents would be affected by the measure, and I hope to offer some reassurance on that issue.
The proposed measure will still allow non-active sole traders to set up to £25,000 of losses sideways, with any unrelieved losses going forward against future profits. When genuine businesses make losses in the initial years, that will be on the expectation of profit in future years, the tax on which can be reduced by carrying forward the remainder of the losses not covered by the £25,000 limit. That concern was raised by the Chartered Institute of Taxation. This measure does not prevent losses from being set against profits from the same trade. An individual will not, therefore, be taxed on more than 100 per cent. of their net profits after losses from the same trade over the life of the trade.

Philip Hammond: The point made was that an individual could find that they were being taxed effectively on 100 per cent. of their income in a given year. The Financial Secretary rightly says that losses can be carried forward for use in the same trade, but that does not reflect the reality of somebody struggling to start up a business. It is of no help telling someone in that situation that he cannot pay the gas bill this year, but that he should not worry, because he can offset his losses against his massive profits in three years’ time. That shows once again that the Government do not understand the problems facing small businesses and entrepreneurs.

Jane Kennedy: I am assured that that will not be the impact. As always, I listen to the hon. Gentleman’s arguments because his work is thorough. I have already accepted that there is some concern, and I have looked at that carefully. However, there will not be many individuals who carry on that kind of business on their own account in a non-active capacity—I will say more about the 10 hours in a moment—who make losses substantially in excess of £25,000 and have other income significantly above that figure against which sideways loss relief could be claimed. They will still be able to claim genuine losses of up to £25,000 against their other income and gains, and where losses are not immediately relievable they are not lost but can be set against income from the business for other years. I hear that the hon. Gentleman says that that is not realistic, but we have to balance the benefit of preserving unlimited relief for a small number of genuine non-active traders against the cost of the exploitation of the relief, which is a problem.

Philip Hammond: Will the Financial Secretary give way?

Jane Kennedy: If I could just demonstrate the reality of that, the revenue figures that I quoted earlier are for this year’s measure. The £1 billion refers to the total sideways loss relief avoidance being closed down both this year and last year.

Philip Hammond: Will the Financial Secretary give way?

Jane Kennedy: Yes, but I have quite a bit to say.

Philip Hammond: Perhaps it is easier if we deal with the issues as they come up, and as the Financial Secretary responds to them. She said that we have to balance the risk of damaging genuine sole traders and entrepreneurs against the risk to the revenue of abuse of the process. I say that we do not have to make that trade-off. We can target the legislation by introducing a motive test. None of us had suggested that people abusing the film tax credit scheme to siphon off hundreds of millions of pounds should not be dealt with, but she asks us to believe that it is beyond the Government’s capability to target the measure on contrived arrangements involving film tax credit claims. She could do that if she put her mind to it, and avoid overspill of the measure affecting entrepreneurs and start-up businesses in a way that she says she does not intend, and about which we have grave concerns.

Jane Kennedy: I will come to the question of a motive test. I fear that we will not agree, although I had hoped—

Peter Bone: I am interested in the Financial Secretary’s argument about the £25,000 relief. That is an interesting starting point, but why is it so low?

Jane Kennedy: In looking to take anti-avoidance measures for this scheme, I was advised that on balance that was the best level at which to pitch the relief. We were satisfied that the £25,000 limit struck the right balance. It must prevent avoidance activity, but allow most individuals to remain unaffected. We will keep the amount under review. We are dealing with a particularly aggressive form of avoidance, where promoters have consistently adapted their schemes to challenge the intention of existing legislation. We had to deal with that last year when we looked at partnerships. Reliance on a motive test, as the hon. Member for Runnymede and Weybridge suggests, would be impractical and would give rise to unacceptable cost and risk. I will say more in a moment.
I have one or two more comments on the 10-hour rule. Many people involved in the avoidance schemes have no active involvement with the business. The 10-hour rule strikes a fair balance between allowing genuine part-timers to carry on without any effect, while ensuring that tax avoiders are not successful. The 10-hour rule has applied in the case of previous restrictions on partnership losses since 2004. It has proved an effective and practical test and I have no reason to believe that what the hon. Gentleman suggests would prove to be true.
The purpose test, which we propose, refers to arrangements made for the purpose of obtaining a reduction in tax. Whether there are avoidance arrangements is a factual matter. There will be many instances where the focus of the loss maker was not tax avoidance and relief will be due. Past experience of the abuse of sideways loss relief has made it abundantly clear that avoiders will take all possible steps to disguise the avoidance as commercial, and that a motive test will not deter them.
I wondered how the amendment tabled by the hon. Member for Runnymede and Weybridge would work, as on my understanding it is not technically correct. Trade loss relief is not available unless the trade is commercial. If a trade is carried on with the intention of making a loss, it would not be commercial and trading losses would not be allowable. The test would make the annual limit restriction redundant as there would be no losses to restrict if the trade was not commercial. That is an incredibly logical argument against the amendment.
We need a mechanism that will deter promoters from instigating such schemes and individuals from entering into them. The annual limit provides that extra deterrent by making it uneconomic to challenge the intention of the legislation. The proposed amendment would make the annual limit apply only when a trade is carried on with the intention of generating a loss for tax-avoidance purposes. Where that is the case, there is no need for an annual limit as losses would not be allowed because the trade is not commercial. It would not provide the necessary deterrent and it would give rise to unacceptable levels of cost and risk in enforcing the application of the motive and purpose tests.
I am convinced that the right combination is a purpose test and the annual limit of £25,000 provided for in the clause. I have a slim hope that the hon. Member for Runnymede and Weybridge will accept my response to his argument and that he will agree to withdraw the amendment. If not, I shall ask my hon. Friends to oppose it and support the schedule.

Philip Hammond: This is an important debate and the Committee stage is designed for exactly this purpose. At one level, what the Financial Secretary says is entirely reassuring. She tells the Committee that the measure is designed only to deal with artificial schemes being marketed to high-net-worth individuals using film tax credits. Our concerns relate entirely and exclusively to the impact of such measures on people who are not involved in any way in such schemes.
I could stand here, think that I have misunderstood the whole thing and accept the Financial Secretary’s reassurances at face value. The problem is that all the outside bodies who have drawn attention to the problems and the risks implicit in schedule 21, have not understood it in the way that she has presented it. Let me ask the Financial Secretary a specific question. At the beginning of her remarks she said that this related to the abuse of film tax credits only. That is why she mentioned the UK Film Council. In the schedule, there is no reference to the provision applying only to arrangements that involve the use of film tax credits. If it said that in the schedule, this debate would not have taken place and none of the concerns would have arisen. However, it does not say anything about film tax credits, except that authorised film funding arrangements are excluded from the scope of the provisions. Were she able to confirm for the record that in practice only arrangements involving film tax credits will be caught by the provisions, even if that means telling the Committee that the Revenue will use its discretion so that those who are not involved with film tax credits are not caught by the legislation, I would feel quite satisfied. I do not know whether my hon. Friends would agree.
The Financial Secretary also mentioned in the course of her last remarks that the Government were proposing a purpose test. She implied that their purpose test was superior to my motive test and that therefore the amendment was unnecessary. I can see the purpose test in relation to the disallowance of relief altogether under new section 74B, but my understanding is that there is no purpose test in new section 74A—if there is one and she can draw my attention to it, I stand to be corrected. It is precisely because new section 74A does not appear to be limited by an effective purpose test that we have sought to reinforce the existing provisions of section 66 of the Income Tax Act 2007 with the introduction of the motive test in amendment No. 136.
We are genuinely seeking after the truth. It may be that the schedule will not impact the serial entrepreneur who has never been anywhere near a film or any film funding arrangement, has never purchased an avoidance or tax-planning scheme from a firm of accountants and is simply someone who has established a small business and gone on to establish another and another; or, to take a different example, a highly paid investment banker in the City who, instead of consuming all his income on expensive champagne, decides to use some of it to start a business. That business might not trade successfully in its first year and might incur losses of £50,000, £60,000 or £100,000, which that individual might be reassured can be set against his six-figure income from his employment. It is those sorts of cases that we seek to protect and if the Minister can assure us in those terms we will be satisfied, but I have not heard such an assurance yet. I will be grateful if she can provide that assurance in the fullness of time, but if she cannot we shall have to press the amendment to a Division and resist the inclusion of the schedule, precisely because of our concerns about the unintended consequences of the measure.

Jane Kennedy: I do not know whether I am supposed to ask leave of the Committee to take a second chance. Although it will not help to reconcile the differences, it will be helpful to the Committee if I clarify that the measure that we are debating applies to trades generally, except to old film reliefs and Lloyd’s. I do not know whether that offers the hon. Gentleman the reassurance that he seeks. The purpose test that he said he was looking for is in new section 74B. I undertake to study carefully the representations that he has made this afternoon and test them against the advice that I have had, but I cannot give him any further assurances at the moment.

Philip Hammond: To deal with the purpose test first, as I said, I see it in new section 74B, but that deals with the disallowance of any relief at all. It does not disapply the cap where mischievous purpose is not present.
That is our concern: even where there is no relevant tax avoidance arrangement, the £25,000 cap will still apply. Despite the Minister’s statement that the measures will apply only to the abuse of film tax credits, the Government have created a juggernaut. She says that £1 billion in tax is at risk from the abuse of film tax credits, but the measures are not tailored tightly to deal with film tax credits. Perhaps they could include a reference to the use of film tax credits. I do not see why not, as the film tax credit scheme is a specific scheme and, as far as I am aware, no similar arrangements could be substituted by those trying to develop avoidance schemes.
The Government have created a juggernaut to deal with the problem as they perceive it, and the Minister appears supremely unconcerned that along the way it will run down innocent entrepreneurs who are struggling or planning to start up businesses and seeking reassurance that if they make a loss, they will at least be able to offset it against profits from other businesses or earnings from employment. The £25,000 limit, although it will provide some reassurance to those operating at the bottom end on a small scale, will not really help where any larger-scale business operation is involved, particularly where capital investment is being made and amounts up to the new annual allowance might thus be available in the first years of a new business, in addition to any trading losses, to offset against other income streams.
If the Minister cannot offer us any further assurance, I must ask my hon. Friends to vote in favour of the amendment and against the schedule as it stands. If anything, her remarks have heightened my concerns. It is clear that there is a purpose that will drive HMRC in applying the measures—trying to shut down abuse of the film tax credit is a perfectly legitimate purpose—but it is equally clear that the Government have not succeeded in making their intervention a targeted one. There will be collateral damage, and we must make a stand to protect those who would suffer from it.

Question put, That the amendment be made:—

The Committee divided: Ayes 7, Noes 12.

Question accordingly negatived.

Motion made, and Question put, That the schedule be the Twenty-first schedule to the Bill:—

The Committee divided: Ayes 12, Noes 7.

Question accordingly agreed to.

Schedule 21 agreed to.

Clause 58

Non-active partners

Question proposed, That the clause stand part of the Bill.

Philip Hammond: Briefly, the clause will amend the wording of a provision that was introduced only in the Income Tax Act 2007. The situation is becoming ludicrous. The Government thought that the definition in that Act was right, but now they are introducing the additional provisions that we have just discussed in schedule 21. They have a different definition, and wish to go back and change the definition that they introduced last year. Why can they not think ahead so that we do not constantly have to revise legislation that we have recently passed? More specifically, what caused the Financial Secretary to decide that the new definition in schedule 21 should be applied in the 2007 Act rather than import the 2007 definition into schedule 21? Why have they decided that they got the development of the definition in the 2007 Act wrong?

Jane Kennedy: To a degree, this is a continuation of the previous debate. The change that we are discussing ensures that the measures that we were forced to put in place last year to tackle the continued misuse of sideways loss relief for tax avoidance purposes are consistent in this Finance Bill and the last for partners and sole traders. The clause aligns the definition of non-active partner for the purposes of restrictions on sideways loss relief with the new definition of non-active capacity for individuals other than partners. As we discussed in the last debate, the existing 10-hour rule requires an individual to spend an average of at least 10 hours a week personally engaged in activities carried on for the purposes of the trade. I have said that that has proved to be effective and a practicable test, but increasingly, avoiders are undertaking activities with no commercial value and claiming that they are for the purposes of the trade.
The reason that we need to keep amending the definition is that avoiders continue to push the boundaries of the definitions and to find ways around them. The hon. Member for Runnymede and Weybridge asks why we should import one definition instead of the other. We are making this change so that we can use the definition that we believe is effective and will work. We believe that it will deter attempts to circumvent the rules. I hope that clause 58 will be supported and will be put on the statute book.

Question put and agreed to.

Clause 58 ordered to stand part of the Bill.

Clause 59 ordered to stand part of the Bill.

Schedule 22

Avoidance involving financial arrangements

Philip Hammond: I beg to move amendment No. 137, in schedule 22, page 279, line 21, leave out from ‘(1A)’ to ‘when’ and insert
‘Any credits or debits relating to any amount which would otherwise fall’.

Jimmy Hood: With this it will be convenient to discuss amendment No. 138, in schedule 22, page 279, line 26, after ‘advantage’, insert
‘as a result of that amount being treated as a distribution’.

Philip Hammond: On the version of the amendment paper that I have, the line number reference for the amendment is incorrect. I do not know whether that is a printer’s error or mine. The line that would be left out is line 21 on page 279, not line 26. I hope that no one on the Committee has been misled by that.

Jimmy Hood: Order. The amendment paper that I am reading from refers to line 21.

Philip Hammond: I am glad to hear that the mistake has been corrected since this amendment paper was published on Tuesday. I wanted to ensure that nobody on the Committee was misled.
This is another measure introduced in the name of anti-avoidance. I understand that it, too, is the result of notification schemes under the legislation requiring such notification. Schedule 22 contains measures to prevent certain types of avoidance involving financial products, specifically the kind of products that give rise to interest-like income being delivered in a form that is non-taxable. The schedule will cover schemes relating to disguised interest where arrangements are entered into to avoid tax on returns that are economically equivalent to interest. It will cover the factoring of rents under a lease of plant and machinery, which makes rental receipts not subject to taxation.
The Government originally proposed in a consultation document of December 2007 that broadly drafted principles-based legislation would be introduced from 1 April 2008 to counter avoidance relating to disguised interest and sales of income streams—that is to say the factoring of leasing income. That consultation prompted a widespread concern among practitioners that the proposals were very broad and were likely to be drafted in a way that would create high degrees of uncertainty for taxpayers and once again give HMRC excessive discretion to interpret the law as it sees fit. Recognising that they cannot afford to inflict any more damage on the UK’s reputation as a stable and predictable place to do business, the Government have bowed to pressure from the professional bodies and deferred the introduction of the new disguised interest rules until 2009. I hope that the time between now and then will be used for proper consultation in an attempt to ensure some certainty about the measures when they are introduced. Unless the Minister tells us otherwise, the Committee must operate on the presumption that the measures will have a life of one year only and that we must expect alternative, principle-based arrangements to be introduced under the Finance Bill 2009 amending what will become the Finance Act 2008.
I turn to amendments Nos. 137 and 138. Paragraph 3 of schedule 22 will insert proposed new section 1A into paragraph 1 of schedule 9 to the Finance Act 1996, and is designed to counter certain arrangements, particularly those involving cross-border financing debt transactions, whereby payments corresponding economically to interest are treated as distributions and therefore fall outside the scope of the UK tax system. The proposed new section applies where amounts would otherwise constitute
“a distribution in respect of a loan relationship”.
Under the provisions, such avoidance techniques will be countered by a one-sided tax charge. The relevant amount paid by a UK resident company is treated as a non-deductible distribution for its tax computation purposes, but a UK resident recipient company will find that the payment is treated as taxable. However, overseas resident company are not be affected in the same way, which is the situation that the legislation is designed to counter. As I understand it, however, where a payment is received by a UK resident company, there will be a lop-sided, asymmetrical tax treatment.
The proposed new section is very broad in its potential application, in part because the arrangements to which it can apply are defined by reference to the broad definition of tax advantage—

Jimmy Hood: Order. If the hon. Member for Wellingborough leaves the Committee Room, the Committee will be inquorate.

Peter Bone: On a point of order, I shall remain to keep the Committee quorate, but is it not the job of the Government to keep the Committee quorate?

Jimmy Hood: I take the hon. Gentleman’s point and thank him for keeping the Committee quorate. That is certainly something that the Government should keep their eyes on. Had it not been for his good grace, the Committee would have been inquorate.

Philip Hammond: During my 11 years in this place, people have resorted to various techniques to shut me up, but I do not remember anyone ever seeking to make a Committee inquorate to do so. I am grateful to my hon. Friend the Member for Wellingborough, but unfortunately he might have established a precedent.
I was saying that the application of the proposed new section is very broad. The arrangements to which it can apply are defined by reference to the definition of tax advantage in section 840ZA of the Income and Corporation Taxes Act 1988, whereas the target of this Bill is, or should be, arrangements where a tax advantage is derived from the treatment of the relevant amount as a distribution, rather than as interest on a loan relationship. I have some sympathy with HMRC’s approach. I suspect that that approach underlay our disagreement over schedule 21. I understand that people charged with undoing tax avoidance opportunities tend to prefer broader legislation, which will be one step ahead of the avoidance industry. However, the danger with that is that we get broadly drafted legislation, which may have unintended consequences specifically. More generally, that plays to what I am afraid is becoming an important theme: the UK is no longer a clear, certain place to do business, with a tax code that is easily understandable and applied consistently. As the UK tax code has got longer and more complex—it has doubled in length under the Government—it has become more and more difficult for people to predict how they will be treated. Uncertainty is a cost of business: uncertainty about the application of the tax code is as much a cost to be factored in to an investment decision as an extra tax. The complexity of the tax system has the negative impact for the economy of additional tax, without the positive aspect for the Exchequer of an additional tax. It is the worst of all worlds, moving us one stage further down the road of international uncompetitiveness.
The purpose of the amendments is to limit the new provision to its intended target. Amendment No. 138 specifically narrows the definition of “tax advantage” to one arising from the “amount” being “treated as a distribution”. It also seeks to ensure that the tax treatment is symmetrical in cases where the new rules could apply to transactions between UK resident companies. Amendment No. 137 includes reference to “credits” as well as “debits”, so that we ensure that there is symmetrical treatment. When a debit is taken out of calculation for the purposes of the tax computation of the paying company, then the corresponding credit is also taken out of the computation for the purposes of calculating the tax liability of the recipient company.
The amendments go some way towards refocusing the clause on its original intention. I stress to the Minister that we are not seeking to change the intended impact of the provisions—this is not a wrecking amendment. It is intended to give her an opportunity to reassure the Committee that the focus of the intended clampdown is narrow and is not intended to create an asymmetric treatment where the payment is made between two UK companies. Frankly, it might help her to bring some political clout to bear, ensuring that the understandable official preference for wider drafting is not allowed to prevail, but rather political common sense and the Government’s own political agenda. While the Government seek to close down tax avoidance, they are also seeking to maintain the competitiveness of British business and, by implication, the clarity and certainty of our tax code—that agenda prevails over the official convenience agenda, which HMRC quite understandably will always push.

Jane Kennedy: Work on principles-based legislation is ongoing for the Finance Bill 2009 and will, as the hon. Gentleman suggests, replace possibly much of the detailed legislation. I hope that I can reassure him that this legislation only applies where there is a tax avoidance motive. If there is no such motive, the legislation does not apply. The principles-based legislation on which we are consulting seeks a simpler approach to countering tax avoidance.
In response to the hon. Gentleman’s regular attack on the length of the tax code, I will say that the tax law rewrite group has been involved in a major piece of work. I have debated that with officials within the Department since taking up the post, and it has become clear to me that using simpler language and breaking up the density of tax law to make it easier to understand and more accessible has led to greater length, but also to the benefit of clarity.
HMRC has been notified of a number of schemes that involve companies designing securities so that they are treated as paying distributions rather than interest. The amounts paid are equal to the returns that would be paid on an investment at interest but are claimed to be non-taxable because of the distributions rules. The debtor company will generally be party to an arrangement that allows it to obtain a tax deduction for the amount treated as a distribution, or it is unconcerned about whether it obtains such a deduction because it has losses and does not pay tax. On Budget day, we announced that we were countering those schemes by removing the tax-exempt status of distributions from loans where the distributions arise in consequence of or in connection with any arrangements that have as one of their main purposes the production of a tax advantage for any person.
We cannot accept the amendments proposed. If amendment No. 137 were accepted, companies would be allowed to obtain deductions for payments that are currently non-deductible because they are classified as distributions when paid in connection with tax-avoidance arrangements. That would provide companies with a fiscal incentive to facilitate tax-avoidance, based upon their entering into arrangements that are designed to allow another company to avoid corporation tax. Amendment No. 138 would confine the effect of the changes to one form of tax-avoidance where the tax advantage arises from treating interest as a distribution. In practice, it is highly likely that the tax advantage would arise from treating the interest as a distribution, but there is no reason to restrict the rule to such cases. For instance, if the tax advantage arose from some other aspect of the arrangement, such as a tax distribution being sought for a drop in the value of the loan relationship caused by the payment of the distribution, there is no reason for the new rule not to apply. Companies not actively engaging in tax-avoidance have nothing to fear from the changes.
After that short debate, I hope that I have been able to reassure the hon. Member for Runnymede and Weybridge and that he will not press the amendment.

Philip Hammond: I am not sure that I quite follow the penultimate paragraph of the Minister’s speech, but I will look at it in Hansard. Once again, she made a perfectly reasonable case, but I think that I, too, made a perfectly reasonable case. Members of the official Opposition are not saying that we want to protect artificial arrangements that give rise to artificial tax savings. She has acknowledged that it is likely that the abuse that she wants to target arises from the treatment of an amount as a distribution, but our sole concern is that by drafting the legislation widely and being unwilling to confine herself to a narrow definition, she is running the risk of collateral damage, and that is a recurrent theme.
We all agree about the 99.5 per cent., but on the one hand, we disagree on whether we should say, “Keep it narrow and run the risk that next year you will have to put something else in place if someone somehow gets into the last half per cent. and levers it open.” On the other hand, she is saying “Well, I don’t really care if there is some collateral damage and a few people we didn’t intend to be caught by the measure are unfairly caught by it, because we have a bigger job to do in shutting down a tax avoidance scheme.”
There is a difference in approach that reflects how one views the relationship between the citizen and the state. If we are of the view that it is important to maintain the balance and not allow the state always to take the over-mighty approach, we should err on the side of caution and apply anti-avoidance legislation that is properly targeted at the abuses that are occurring. We know, because the Minister has told us, that if other abuses open up, she has powers to intervene rapidly and, if necessary, retrospectively to the date of an announcement, to expand the scope of anti-avoidance legislation. However, such a generalised approach that does not target specific mischief runs the risk of causing collateral damage.
I am sure that we will return to this theme. I shall not detain the Committee by pressing the amendments, but I hope that the right hon. Lady will consider the general theme—I know that she thinks about such things—and challenge her own officials on whether the measures are necessary. My hon. Friends and I have not dreamed up politically motivated points; by and large, they reflect points that have been raised in discussion, particularly with the professional bodies, which see the potential for unintended consequences.
If the Minister thinks back to our discussions today, she will recall that on at least one occasion—in the Finance Act 2007—she had to introduce legislation to correct unintended consequences and ensure that the taxpayer was not disadvantaged vis-Ã -vis the Government’s intentions. I give her notice that we will come back to the matter later in the Bill’s progress, but I beg to ask leave to withdraw the amendment.

Amendment, by leave, withdrawn.

Amendment proposed: No. 127, in schedule 22, page 279, line 34, at end insert—

‘Disposals for consideration not recognised by accounting practice
3A (1) In Schedule 9 to FA 1996 (loan relationships: special computational provisions), after paragraph 11A insert—

“Disposals for consideration not fully recognised by accounting practice
11B (1) This paragraph applies where in any accounting period (“the relevant accounting period”) a company, with the relevant avoidance intention, disposes of rights under a creditor relationship (in whole or in part) for consideration which—
(a) is not wholly in the form of money or a debt that falls to be settled by the payment of money, and
(b) is not fully recognised.
(2) The relevant avoidance intention is the intention of eliminating or reducing the credits to be brought into account for the purposes of this Chapter.
(3) Consideration is not fully recognised if, as a result of the application of generally accepted accounting practice, the full amount or value of the consideration is not recognised in determining the company’s profit or loss for the relevant accounting period or any other accounting period.
(4) In determining the credits to be brought into account by the company for the period for the purposes of this Chapter, it is to be assumed that the whole of the consideration is recognised in determining the company’s profit or loss for the relevant accounting period.
(5) But this paragraph does not apply if paragraph 1(2) of Schedule 28AA to the Taxes Act 1988 (provision not at arm’s length) operates in relation to the disposal so as to increase the tax liability of the company.”
(2) In Schedule 26 to FA 2002 (derivative contracts), after paragraph 27 insert—

“Disposals for consideration not fully recognised by accounting practice
27A (1) This paragraph applies where in any accounting period (“the relevant accounting period”) a company, with the relevant avoidance intention, disposes of rights or liabilities under a derivative contract (in whole or in part) for consideration which—
(a) is not wholly in the form of money or a debt that falls to be settled by the payment of money, and
(b) is not fully recognised.
(2) The relevant avoidance intention is the intention of eliminating or reducing the credits to be brought into account for the purposes of this Schedule.
(3) Consideration is not fully recognised if, as a result of the application of generally accepted accounting practice, the full amount or value of the consideration is not recognised in determining the company’s profit or loss for the relevant accounting period or any other accounting period.
(4) In determining the credits to be brought into account by the company for the period for the purposes of this Schedule, it is to be assumed that the whole of the consideration is recognised in determining the company’s profit or loss for the relevant accounting period.
(5) But this paragraph does not apply if paragraph 1(2) of Schedule 28AA to the Taxes Act 1988 (provision not at arm’s length) operates in relation to the disposal so as to increase the tax liability of the company.”
(3) The amendments made by this paragraph have effect in relation to disposals on or after 16 May 2008.’.—[Jane Kennedy.]

Jimmy Hood: With this it will be convenient to discuss Government amendment No. 128.

Philip Hammond: The Minister is making a good attempt at progress, but I am afraid that she will have to work for her ministerial salary.
As we have been discussing tax law rewrites and making things nice and plain, I draw the Minister’s attention to Government amendment No. 128. Proposed new paragraph (2D) of schedule 9 to the Finance Act 1996 says:
“This paragraph does not apply where—
(a) the transferor company is party to arrangements...in circumstances in which this paragraph would not apply”.
So the paragraph will not apply in circumstances in which it will not apply. To me, that does not sound like the kind of plain English of which the tax law rewrite project would approve. I cannot understand what the words at the end of new paragraph (2D)(a) mean when read in conjunction with the words at the opening of paragraph (2D).
I shall leave the Minister to ponder that for a moment. The changes introduced by the amendments are, as I understand it, designed to block tax planning where financial assets are sold without the market value of the proceeds being taxed and, effectively, without their being recognised. Of course we support measures to deal with any non-commercial, non-arm’s-length transaction that gives rise to a tax advantage. However, the wording of new paragraph 11B, which is inserted by amendment No. 127 into schedule 9 of the Finance Act 1996, could apply more widely than the right hon. Lady thinks—we go back to our familiar theme—and could catch normal commercial transactions where a loan is exchanged for shares in a company, for example because of a debt for equity swap. This is not an artificial transaction. This could be a transaction where, because of the financial condition of the borrower, the provider of the loan has no alternative but to exchange the debt for equity. Companies holding such loans would be taxed if they had a relevant avoidance intention, defined as the intention not to be taxed on the loan interest receivable.
Given that any debt for equity swap will result in an instrument giving rise to taxable income—the loan—being replaced with an instrument that is taxed on a capital gains basis—the shares—there is a concern that this provision will catch normal transactions. “Normal” is perhaps not the right term, as a debt for equity swap is fairly unusual, but it is a perfectly legitimate commercial transaction. Moreover, given the present conditions in the credit market, we might expect to see more forced debt equity swaps in the near future.
There is therefore a concern that a normal commercial transaction which replaces a loan with shares could easily be argued to have a purpose of avoiding tax on the loan income. When one swaps interest-bearing debt for equity, one surrenders the opportunity, albeit theoretical, of receiving interest on the loan. I should be pleased to hear the Minister’s specific answer to those questions. Can she reassure the Committee that this unintended consequence will not arise?

Jane Kennedy: I have said before in Committee, in that well-known Liverpool phrase, “God loves a tryer”, and I did seek to try it on. Amendments Nos. 127 and 128 address two interchangeable avoidance schemes. It is estimated that unless both schemes are closed, the loss of tax will be £200 million per annum. The two schemes have been disclosed to HMRC under disclosure rules. The rules for taxing companies on their loans and derivatives are accounts based, with the result that profits are generally chargeable to tax only if the profits are recognised in the accounts in accordance with generally accepted accounting practice.
One scheme that has been disclosed allows companies to sell their loans and derivatives without triggering recognition of any accounting profit. Amendment No. 127 prevents a scheme from working where a loan or derivative is sold in return for shares. Then for tax purposes the full market value of the shares will have to be brought into account as the sale proceeds. But to ensure that this does not apply in inappropriate circumstances, the amendment can operate only where the disposal is made with the object of reducing the profits to be brought into account.
The hon. Member for Runnymede and Weybridge asked about transfer. I am grateful to him for drawing my attention to paragraph 3B. There is an explanation but, frankly, it is quite complicated and it is probably better if I write to the Committee about that. I shall deal with the second scheme which has been disclosed to HMRC. It also aims to allow companies to realise profits without attracting a tax charge. As the hon. Gentleman will know, the rules for taxing companies’ loans and derivatives have group continuity divisions.
In the newly notified scheme, companies with derivative contracts or loans with a market value in excess of their historic cost and their accounts carrying value sell the contracts or loans at full value to a partnership of which the other members are fellow group companies. That gives rise to an accounting profit to the transferor, but it is claimed that that profit is not taxable because the group neutrality rules apply. Subsequently, another company joins the partnership in return for making a contribution to the capital of the partnership equal in value to the asset transferred to that partnership. The new partner then becomes entitled to virtually all of the partnership’s profits, including any rights in respect of the asset. That means that, in substance, the asset has been sold to the new partner, but it is claimed that no tax charge arises.
Government amendment No. 128 prevents that scheme from working. The group neutrality rules will not apply where the transfer of an asset to which those rules would otherwise apply is made as part of an arrangement that aims ultimately to transfer the asset outside the group. Again, to ensure that that does not happen in inappropriate circumstances, the amendment can operate only where the disposal is designed to avoid tax.

Philip Hammond: I am sorry to break the Minister’s flow, but I would like to take her back to the first part of what she said. The Minister sought to reassure the Committee that the provisions would apply only where the activity is designed to reduce or eliminate taxable interest. I am seeking confirmation that that could not be deemed to have arisen because of a debt/equity swap and that a debt/equity swap per se would not be treated as a transaction designed to eliminate what would otherwise be taxable interest payments.

Jane Kennedy: This is a very complex area, and I want to ensure that I get this right. I will study Hansard and read both what he and I have said to ensure that I have been clear. In a standard debt/equity swap there is no intention of reducing taxable profits—although that might be an effect, it is not the intention. Therefore, the legislation would not apply.

Philip Hammond: So, if I hold a loan note from company X that entitles me to receive £10,000 a year interest, which will be taxable in my hands, and I agree to swap it for equity in company X, which may or may not give rise to dividends, but certainly will not give rise to taxable interest payments, then that will not be regarded as an act taken to avoid tax on that interest stream. If that is what the Minister is saying, I think that that satisfies the concerns raised.

Jane Kennedy: It is. As I have said, this is a very complex area, but that is my understanding of the arrangements. I have already explained Government amendment No. 127. Government amendment No. 128 will prevent the second scheme from working. I hear the hon. Gentleman’s point about the unintended consequences of some of this work. I am following this carefully and I hear the theme that he is developing as we go through the Bill. I am satisfied that the anti-avoidance action is necessary. As I have said, the schemes that Government amendments Nos. 127 and 128 deal with are interchangeable. Unless both schemes are closed, the loss of tax is estimated at £200 million per annum. Therefore, I hope that both amendments will be accepted.

Amendment agreed to.

Amendment made: No. 128, in schedule 22, page 279, line 34, at end insert—

‘Avoidance relying on continuity of treatment provisions
3B (1) In paragraph 12 of Schedule 9 to FA 1996 (loan relationships: continuity of treatment), after sub-paragraph (2C) insert—
“(2D) This paragraph does not apply where—
(a) the transferor company is party to arrangements in accordance with which there is likely to be a transfer of rights or liabilities under the loan relationship by the transferee company to another person in circumstances in which this paragraph would not apply, and
(b) the purpose, or one of the main purposes, of the arrangements is to secure a tax advantage for the transferor company or a person connected with it.
(2E) In sub-paragraph (2D) above—
(a) “arrangements” includes any agreement, understanding, scheme, transaction or series of transactions,
(b) “tax advantage” has the meaning given by section 840ZA of the Taxes Act 1988, and
(c) “transfer” includes any arrangement which equates in substance to a transfer (including an acquisition or disposal, or increase or decrease, in a share of the profits or assets of a partnership);
and section 839 of the Taxes Act 1988 (connected persons) applies for the purposes of that sub-paragraph.
(2F) This paragraph does not apply in relation to a disposal if paragraph 11B above applies in relation to it.”
(2) In paragraph 28 of Schedule 26 to FA 2002 (derivative contracts: continuity of treatment), after sub-paragraph (3ZA) insert—
“(3ZB) This paragraph does not apply where—
(a) the transferor company is party to arrangements in accordance with which there is likely to be a transfer of rights or liabilities under the derivative contract by the transferee company to another person in circumstances in which this paragraph would not apply, and
(b) the purpose, or one of the main purposes, of the arrangements is to secure a tax advantage for the transferor company or a person connected with it.
(3ZC) In sub-paragraph (3ZB) above—
(a) “arrangements” includes any agreement, understanding, scheme, transaction or series of transactions,
(b) “tax advantage” has the meaning given by section 840ZA of the Taxes Act 1988, and
(c) “transfer” includes any arrangement which equates in substance to a transfer (including an acquisition or disposal, or increase or decrease, in a share of the profits or assets of a partnership);
and section 839 of the Taxes Act 1988 (connected persons) applies for the purposes of that sub-paragraph.
(3ZD) This paragraph does not apply in relation to a disposal if paragraph 27A applies in relation to it.”
(3) The amendments made by this paragraph have effect in relation to transactions taking place, or a series of transactions of which the first takes place, on or after 16 May 2008.’.—[Jane Kennedy.]

Philip Hammond: I beg to move amendment No. 139, in schedule 22, page 280, line 7, at end insert
‘to the extent that such debits exceed the aggregate amount of credits brought into account under this Chapter in that or any previous accounting period in respect of that share’.

Jimmy Hood: With this it will be convenient to discuss the following amendments: No. 140, in schedule 22, page 280, leave out line 8.
No. 141, in schedule 22, page 280, line 13, at end insert
‘to the extent that such debits exceed the aggregate amount of credits brought into account under this Chapter in that or any previous accounting period in respect of that share.’.
No. 142, in schedule 22, page 280, leave out line 14.

Philip Hammond: The main object of the provisions is to prevent the rules in the Finance Act 1996 under which certain shares are treated as debt from being manipulated deliberately to create artificial debits by reference to a fall in the fair value of the relevant shares. The Bill deals with the issue by denying the holder of such shares any debits under the loan relationship rules. That is fair enough. We have no dispute with the purpose of the provision, only with the fact that it is too broad.
If all debits are denied, a holder may, for example, be taxed on a fair value increase representing an interest accrual, but will be unable subsequently to claim relief if the return becomes unrealisable because the underlying debt is impaired. He will, in effect, have been taxed on the accrual of the interest when it was expected that it would be paid, but be unable to obtain an unwinding of the tax effect if that debt becomes impaired and it is apparent that he will not receive the payment.
Amendments Nos. 139, 140 and 141 would address the issue by allowing debits when credits have previously been brought into account. It is a restrictive set of circumstances, but something that seems entirely equitable. It would provide appropriate protection for the Exchequer by limiting the debits that are available in respect of such shares to amounts that are equal in aggregate to the amount of credit previously brought into account under the loan relationship rules. Our amendments would limit the scope of the changes so that they are more appropriately targeted. They would reflect circumstances when in a loan relationship debits would be allowed. When that would be the case in a loan relationship and the matter at issue was the fair value of shares, such measures would ensure that the debit was allowed to reflect the unwinding of a position that had previously given rise to an increase in value that causes a credit.
I hope that the Minister accepts that the amendments are intended to deal with circumstances in which the schedule would be unfair to the taxpayer. I am interested to hear her comments.

Jane Kennedy: We announced on Budget day that we intended to introduce a package of measures to amend existing legislation known as the shares as debt rules. One of the changes was that, when the shares as debt rules apply, no losses may be brought into account in respect of any share to which the rules apply. That was in response to a number of schemes notified to HMC that were designed to create artificial losses through the use of intra-group, depreciatory transactions.
I appreciate that the amendments might be of a probing nature, but they would qualify the rule preventing relief for losses by providing that debits should still be allowed to the extent that they do not exceed profits that have previously been taxed in respect of the share in question. If a profit of, say, 10 is taxed in year 1, the amendment would mean that the company could claim relief for a debit of up to 10 in year 2. Shares as debt rules would apply only if the shares increased in value in the same way as interest, so debits will not arise in normal cases.

Philip Hammond: I think that I understand what the Financial Secretary is saying. I do not suggest that the debit be allowed where the underlying value of shares has fallen. In the example that I quoted, the fall in value was due to the impairment of the receivability of the accrued interest: an accrual of interest gives rise to a tax charge, but it then becomes apparent that the debt represented by that accrued interest has been impaired and will not be paid, and the value of the shares falls accordingly. That should be allowed as a debit on the other side of the calculation.

Jane Kennedy: I hope that what the hon. Gentleman says is right.

Philip Hammond: Does the Financial Secretary mean that she hopes that I am wrong?

Jane Kennedy: Yes; the hour is growing late.
We fear that the amendments would allow avoidance to continue. It is important to bear it in mind that the action that we are taking arises from a number of schemes that have been notified to us. I do not believe that what the hon. Gentleman fears will happen. The shares as debt rules apply only to contrived arrangements. It is the purpose of the arrangements that will be tested. Companies that had been taxed under the shares as debt rules in previous years could enter into a depreciatory transaction in a later year that generated artificial losses equal to past profits. Those losses could be set against other profits, with the result that any tax paid in respect of earlier years could effectively be paid back in a later year. If the amendments were accepted, there would continue to be loss of tax estimated at up to £100 million per year. I therefore hope that the hon. Gentleman will not press his amendments.

Philip Hammond: I hear what the Financial Secretary is saying. It was not the intention to create a further avoidance opportunity, and in the example that she just read out, the assumption was that the tax paid in an earlier period would be offset against a loss arising from another cause in a later period. Perhaps my amendment was not drafted narrowly enough. I sought to deal with the case where there had been an impairment of the value of the accrued income in the share transaction. Would the Financial Secretary be prepared to pursue that by correspondence? If what she says is right, our amendment is too widely drafted. In that case I would like to consider whether there was a narrower drafting that would address the concern that has been raised with me. That concern is the possible unfairness where something that effectively has not been received is taxed on an accrual basis and it then becomes apparent that it will not be received, not because of an artificial transaction but because of a genuine impairment. We must ensure that there is no asymmetry in the tax treatment of a genuine transaction. Even if it were right to tax the original accrued increase in value as part of the anti-avoidance regime, we must ensure that we do not maintain that tax treatment where it turns out that there was no increase in value because the accrual was impaired.

Jane Kennedy: I assume that the hon. Gentleman would want a written exchange before Report so that he had an opportunity to look at the detail. I am happy to undertake to do so, if that would be helpful.

Philip Hammond: That would be extremely helpful, and would allow us to take the Financial Secretary’s concerns back to those who have raised the issues with us. We could look at those concerns with them and perhaps come back to her in correspondence to see whether there was something that could be done, or whether she could give on Report a specific assurance that would deal with that concern. On that basis, I beg to ask leave to withdraw the amendment.

Amendment, by leave, withdrawn.

Jane Kennedy: I beg to move amendment No. 129, in schedule 22, page 280, line 40, at end insert—

‘Non-qualifying shares
10A (1) In section 91B(5)(a) of FA 1996 (debits and credits to be brought into account where Condition 3 in section 91E is satisfied), omit “by the investing company”.
(2) The repeal made by sub-paragraph (1) has effect in relation to credits and debits relating to any time on or after 16 May 2008.’.

Jimmy Hood: With this it will be convenient to discuss the following: Government amendments Nos. 130 and 131,
Amendment No. 143, in schedule 22, page 284, line 28, at end insert—
‘(2A) In section 91A(7) FA 1996 omit the words ‘(see section 103(3A)).’.

Jane Kennedy: Since the publication of the Bill on 29 March, HMRC has listened to representations that in some cases the legislation might have unintended results. Government amendments Nos. 129 to 131 will therefore ensure that the legislation works as intended. In particular, it will not result in double taxation or double relief because the amendments clarify which companies have to bring profits and losses into account, disapply the legislation where companies have already been charged a tax in respect of the amounts that are equivalent to interest and omit a redundant reference to another provision. Amendment No. 143 would repeal a redundant reference.

Philip Hammond: It is the same.

Jane Kennedy: It is the same as Government amendment No. 131 and is therefore unnecessary. I hope that the Committee will agree and that we can make swift work of this group.

Philip Hammond: I am grateful to the Minister for clarifying the situation. She is basically saying that after publishing the Bill, the Government have listened to concerns about an anomaly in the shares as debt rules that were introduced in 2005. They have come forward with a means of correcting that. We should be clear that this has become a pressing issue because of the change in the definition of “commercial rate of interest” introduced in the Bill, which will make the anomaly more widely felt than it was previously. This is therefore a necessary measure and not just a tidying-up exercise.
I must raise one point with the Financial Secretary. For some odd reason, the correction is effective only from 16 May 2008. Companies that are caught by the widened definition of “commercial rate of interest” and subsequently rescued by the amendment will therefore be within the shares as debt rules from 12 March 2008 and come out again on 16 May 2008. That will lead to some anomalous and arguably unfair results. My understanding is that such companies will be taxed not only on the income accruing between 12 March and 16 May, but on a deemed capital gain on 12 March. That seems to be a bizarre and, frankly, unnecessary problem that could easily be resolved by the Government aligning the two dates. It does not matter whether they are aligned on 12 March or 16 May, but it seems utterly bizarre to have the two dates, which produce this odd little bit of income that will be caught in what is effectively a double taxation.
On amendment No. 143, the Government clearly spotted the error before or at the same time as we were alerted to it. Government amendment No. 131 will take care of the problem and we are happy to support it.

Jane Kennedy: The Government amendments were drafted in response to representations from business, as I have said. However, business has not been able to provide any examples of where these unintended consequences have arisen. We decided to table the amendments to eliminate even the remotest possibility of double charges arising. Retrospection is not an option in this case, even if we wanted to introduce it. There could be losers if retrospection were used. HMRC does not accept that the review of interest makes a difference. I think that this group is fairly straightforward and that it should be given a prompt fair wind.

Amendment agreed to.

Amendments made: No. 130, in schedule 22, page 280, line 40, at end insert—

‘Income producing assets
10B (1) In section 91C(3) of FA 1996 (assets which are income producing), for paragraph (c) substitute—
“(c) any share as respects which the condition in section 91D(1)(b) below is satisfied;”.
(2) The amendment made by sub-paragraph (1) has effect in relation to times on or after 16 May 2008.’
No. 131, in schedule 22, page 284, line 28, after ‘Accordingly’, insert—
‘(a) in section 91A(7)(a) of FA 1996, omit “(see section 103(3A))”, and
(b) ’.—[Jane Kennedy.]

Question proposed, That this schedule, as amended, be the Twenty-second schedule to the Bill.

Philip Hammond: I wish to raise a few matters that we have not yet covered in these debates, and I make no apology for delivering them as a series of points.
The concern is that the proposed amendments to sections 91A and 91B introduced by paragraph 4, which prevent debits from being brought into account, create a risk of double taxation when shares such as fixed-rate preference shares are treated by those sections as loan relationships and are taxed on the basis of notional fair value accounting. For example, market fluctuations in interest rates could result in fair value losses on shares in some periods and gains in others. The disallowance of debits representing fair value losses could lead to double taxation to the extent that there were credits representing equal and opposite gains in other periods.
Net debits are more likely to arise in intra-group preference share arrangements, as those are often long-term arrangements. A helpful suggestion might be to introduce something similar to the provision that I am told exists in paragraph 23 of schedule 26 of the Finance Act 2002—the Financial Secretary will be familiar with it—which effectively taxed only the cumulative net credits arising from exchange rate fluctuations. Obviously in this case we are not talking about exchange rate fluctuations, we are talking about interest rate fluctuations. Similarly, if shares are denominated in foreign currency, the fair value will fluctuate with the exchange rate movements. The disallowance of debits representing fair value losses would, on my understanding, lead to double taxation to the extent that there were credits representing equal and opposite gains in other periods. I would be grateful if the Financial Secretary could address that point and, if she has some reassurances, let the Committee know what they are.
There is concern about proposed section 91D (2), which is introduced by paragraph 11 of schedule 22. It extends the definition of redeemable shares to any share where
“it is reasonable to assume that the investing company will or might become entitled to qualifying redemption amounts.”
When that is coupled with the proposed repeal of the definition of the commercial rate of interest in sections 103(3)(a) and (b) of the Finance Act 1996, introduced by paragraph 15, virtually any preference shareholding could be argued as being within the scope of section 91D and therefore taxable as a loan relationship unless proven to have been acquired for a purpose other than tax avoidance.
No one wishes to support tax avoidance, but that places a lot more pressure on the motive test than we have under the current rules. Almost any preference share may be caught, unless the taxpayer can be confident that there is no aspect of its history that HMRC could characterise as “avoidance” of any sort. It seems to give excessive discretion to HMRC and a corresponding lack of certainty to the taxpayer. In the absence of any change to the legislation, HMRC will either have to apply the rule universally, or it will have to untax many companies by non-statutory discretion, meaning more complexity and more uncertainty for business. We believe that legislation that goes over the top and relies on a non-statutory discretion by HMRC is, quite frankly, bad legislation.
A third concern is that there is no holdover relief for shares coming into section 91A or 91B for the first time. The schedule will extend the scope of sections 91A and 91G of the Finance Act 1996 and shares newly brought within their scope are treated under the terms of section 91G as having been disposed of and reacquired on 12 March 2008 at fair value, but there is no provision for holdover of any chargeable gain, or indeed, allowable loss that is crystallised by the deemed disposal. That is in contrast to shares held at the time that sections 91A and 91B were first introduced in 2005. The gradual extension of the rules to catch what are known as sidestepping transactions, which we have seen in the last few amendments to the section 91B regime, has generally been so closely defined that disguised interest-type transactions only were caught and consequently, the resulting capital gains were not significant or at least were uncontroversial. By contrast, the current proposals are so wide in scope that they will catch many shareholdings where the shareholding has been in place for a long period and the shareholder has had no reason to believe that the section 91B regime might be extended to include them because there was no intention to create disguised interest. Consequently, there is much more scope for an unfair capital gain to arise and in some cases the resulting tax liability could do material financial harm to a company.
I have two other points to make. The effect of the amendment to section 91C(6), which is introduced at paragraph 9(3) of the schedule, is to bring within the scope of section 91B shares that would be caught but for the fact that the assets of the company were changed to prevent the shares appreciating in an interest-like way. Once the shares are within the scope of section 91B as a result of the amendment, they are taxed without regard to the effect of the changes to the value of the assets so the interest-like return only is caught. However, the transitional provision does not disregard the return-varying assets, so the section 91G capital gain or loss at the time the company comes into section 91B would be increased or decreased by the fair-value movement on the introduced assets. In a typical case, the interest-like appreciation may be avoided by transferring a derivative contract into the company that issued the shares—I hope the Minister is following this. Gains and losses on the derivative would be taxed under the derivative contracts rules, quite obviously, but under section 91G, the cumulative gain or loss would also be taken into account in computing the chargeable gain or loss arising on 12 March 2008. The point of all this is that the gain or loss at the time of its coming within the scope of section 91B would be double-taxed; once under these arrangements, and once under the derivative contracts rules. Those are areas of concern, and I would be grateful if the Minister addressed them.
I want to raise an issue that the Chartered Institute of Taxation has raised. In addition to the types of arrangements that have been notified under the anti-avoidance notification provisions, the use of bonus issue debentures occurs in a private equity context where a creditor’s ranking in the debt waterfall is upgraded from preferred equity to subordinated debt. There is some doubt—this is an important point that the Minister can answer with a yes or no if advice comes to her in due course—about the applicability of section 209 of the Income Tax Act 1988, and therefore, whether section 212 of ICTA 1988 will apply in those circumstances. Many advisers take the view that section 212 is not applicable, and it would be helpful if the Minister confirmed that if the payer of the interest is paying additional tax because of the non-deductibility of the interest, the fact that the payee is not paying tax on the interest will mean that a main purpose of such arrangements will not be regarded as securing a tax advantage for the purpose of proposed new sub-paragraph (1A) of schedule 9 to the Finance Act 1996. The hope is that the Minister’s officials might have been made aware of that concern following a representation that they have received and that the Minister might therefore be able to confirm in simple language whether those bonus issue debentures are caught.

Jane Kennedy: Here goes. The hon. Gentleman asked me to answer yes or no on ICTA 1988, and I say, yes—a qualified yes—provided that tax paid by the company paying the interest is equal to, or more than, the tax saved by the company that receives it. He asked about transitional provisions regarding varying assets. HMRC considers that that is a theoretical issue only: no one has been able to find any example of it happening. HMRC guidance makes it clear that the payment of dividends does not give rise to fair-value losses, since the dividend is part of the fair-value return. Nor are any exchanged losses likely to reduce the overall return below nil. That means that it is unlikely that there could be debits.
The hon. Gentleman asked about redeemable shares, and he was concerned about what would be caught. There are a number of circumstances in which it is not reasonable to assume that the holder would be entitled to such amounts. For instance, if the subsidiary shares are held as part of the group’s core activities, it is not reasonable to assume that the investing company would sell those shares. There might also be regulatory reasons why it is not possible for certain shares held within a group to be sold off. The tax avoidance test provides protection for the taxpayer.
I hope that I can reassure the hon. Gentleman that HMRC will give case-by-case advice in accordance with its existing code of practice. It will advise companies on the application of the law to a particular transaction if the full facts and circumstances are set out. We have seen no evidence of any legitimate business transactions that rely on the upfront payment of interest. The announcement of this action in the 2007 pre-Budget report was accompanied by consultation with business, during which no evidence of such structures was received. He is right that there will be no hold-over relief. The absence of hold-over provision is not new, however, and was a feature of rules when they were first introduced in 2005. Although schedule 22 is large and complex, it deals with a number of aggressive avoidance schemes. Numerous financial product disclosures received under the regime introduced in the Finance Act 2004 show that the avoidance industry continues to be active. The tax at risk runs to hundreds of millions of pounds, so we believe that it is right to act in the interests of the public services and those taxpayers who comply with their obligations.
I might have missed one, two or possibly more of the detailed questions that the hon. Gentleman asked, but I undertake to write to him if that is the case, and I hope that we can see schedule 22 through to legislation.

Question put and agreed to.

Schedule 22, as amended, agreed to.

Clause 60 ordered to stand part of the Bill.

Schedule 23

Manufactured payments: anti-avoidance

Question proposed, That this schedule be the Twenty-Third schedule to the Bill.

Philip Hammond: I will detain the Committee for no more than a moment. In fact, after reflecting on my notes, I will not detain the Committee at all.

Hon. Members: Hear, hear.

Question put and agreed to.

Schedule 23 agreed to.

Clause 61

Controlled foreign companies

Amendments made: No. 119, in clause 61, page 30, line 26, leave out paragraph (b) and insert—
‘(b) any income which accrues during that period to a partnership of which the company is a partner, apportioned between the company and the other partners on a just and reasonable basis.’.
No. 120, in clause 61, page 30, line 33, at end insert—
‘(4D) In sub-paragraph (4B)(b), “partnership” includes an entity established under the law of a country or territory outside the United Kingdom of a similar character to a partnership; and “partner” is to be read accordingly.”’.
No. 121, in clause 61, page 30, line 42, leave out paragraph (b) and insert—
‘(b) any income which accrues during that period to a partnership of which the company is a partner, apportioned between the company and the other partners on a just and reasonable basis.’.
No. 122, in clause 61, page 30, line 48, at end insert—
‘(5E) In sub-paragraph (5C)(b), “partnership” includes an entity established under the law of a country or territory outside the United Kingdom of a similar character to a partnership; and “partner” is to be read accordingly.”’.—[Jane Kennedy.]

Question proposed, That the clause, as amended, stand part of the Bill.

Mark Hoban: It is a pleasure, Mr. Hood, to serve under your chairmanship for the first time. There are a number of issues that I could have raised in the debate on the previous set of amendments, but I thought that I would focus on clause 61. It is worth bearing in mind the fact that a consultation on the control of foreign companies regime is being carried out at the moment. That is relevant to the clause, because one representative body questioned why changes needed to be made, given that significant reforms are expected in the 2009 Finance Bill. I am sure that the Minister will highlight some mischief that she and the Government wish to stop.
The consultation has moved away from looking at the status of individual entities to focus much more on income streams from things like finance payments, royalties and so on, and that focus seems to be creeping into the clause. There is a shift in definition from the emphasis on control of a company to some of the income that arises. The Law Society, in its comments on the clause, points out that subsection (3) discusses the concept of persons possessing, or entitled to acquire,
“the whole of the income”
of a company. The explanatory notes state that
“a person controls a CFC if they hold a majority of the rights to the CFC’s income or assets”.
The usual definition of control that applies is set out in section 416 of the Income and Corporation Taxes Act 1988, and focuses on someone’s ability to exercise, or be entitled to acquire, direct or indirect control over the company’s affairs. There appears to be a shift away from control, as we would normally see it, as being about the exercise and the power to intervene in the way that a company is run, to the economic rights that come from the income flows and who benefits from them. Would the Minister comment on what appears to be a shift in approach and almost a prelude to some of the things that were floated in the consultation paper? I suspect that the perception is that there is a bit of rowing-back.
Will the Minister define income for the purposes of subsection (3)? Is it distributable profits? If so, why has that not been emphasised in the Bill, and which generally accepted accounting practice applies? If it is not, what is it? Is it the gross income of a company, or is it some definition of chargeable profits? It would be helpful to have some clarification. Given that control appears to depend on who has the majority of the share of income, it would be useful to understand when the test of control applies. If, for example, there are fixed-rate preference shares, the income would accrue evenly over the year. If the company’s profits accrued unevenly and all arose in the second half of the year due to seasonal trade, it would appear that during the first part of the year, the holders of fixed rate preference shares would control the company because they are entitled to the majority of its income if the definition is about profits. In the second half of the year, those holders would lose control.
An alternative scenario is that if the profits of the company were low in one year, the preference shareholders would control the company, because they have the right to the majority of the income, but in a more profitable year, they would lose control of the company. There does not appear to be much certainty in this situation about where control is, because of the lack of definition regarding income. What would happen if someone owned 60 per cent. of the economic rights, but somebody else controlled 60 per cent. of the voting rights? How would income be appropriated between the two holders?
I have a couple of other points to make. The first refers to a previous group of amendments, but the issue flows through this clause. Proposed new subsection (7) refers to income being allocated
“on a just and reasonable basis”,
particularly where
“there is more than one settlor or beneficiary”.
However, “just and reasonable” is not an objective measure and could create uncertainty. The explanatory notes speak of guidance being produced to assist taxpayers. It would be helpful to know what that guidance will consist of, and whether there is a clearer rule that could be reflected in the Bill, rather than through guidance. Such a rule must not lead to opportunities for mischief at a later stage. Proposed new paragraph (ab) in subsection (2)(a) will create two new accounting periods: one that ends on 11 March 2008 and one that starts on 12 March 2008. If a dividend is received between 12 and 31 March, will it be accounted for on a receipts basis or can some of it be allocated to a prior period? Without that allocation, it will be possible for a company to fail the exempt test for the first period.
Finally, I want to raise the implications for the acceptable distribution policy. As I understand it, dividends paid under the acceptable distribution policy can be paid up to 18 months after the year end to which they relate. If a dividend was paid between 12 and 31 March 2008, it could be in respect of an accounting period ending on 30 September 2006. One of the issues is whether the changes under the clause will require people to go back and revisit the level of dividend and tax paid at that point.
It is perhaps worth explaining a bit about the acceptable distribution policy. To be exempt under controlled foreign companies legislation, a company has to distribute 90 per cent. of its profits by dividend. Under the changes, we think that the definition of income could expand so that 90 per cent. will be a percentage of a larger figure, which will require a larger dividend to be paid and therefore incur a larger tax bill. Because of the way in which the changes will interact with the acceptable distribution policy, it is not entirely clear whether people will have to reconsider the amount of dividend that they are paid. Of course, they determine that dividend on the basis of profits incurred before the legislation is introduced. There is therefore a sense of retrospectivity creeping in, because businesses that thought that they knew what their tax liabilities were will have them reassessed as a consequence of the clause. I could carry on discussing the wider issues around controlled foreign companies legislation and some of the problems that the Government have with it, but I am sure that the Committee would welcome the Minister’s response.
Further consideration adjourned.—[Mr. Blizzard.]

Adjourned accordingly at five minutes to Four o’clock till Tuesday 3 June at half-past Ten o’clock.